Understanding Inflation and Interest Rates

Posted by Alexander Grant on 1/24/22 10:35 AM

wallet held in a c-clamp

In a world steeped in gargantuan amounts of debt, we truly have the makings of a significant sovereign debt crisis at some point in the future.

It is arguable that this crisis will occur this decade, or maybe even half-way into the 2030s. The monetary policy loop of governments issuing debt to fund even more debt and spending more money will eventually lead to an inflection point. 

Now, I know what you’re thinking…many pundits have argued that the day of reckoning is always around the corner. Clients of ours who have been in capital markets since the 1970s or 1980s have heard this money supply story for decades. 

So what will the trigger be? When will we know that we are in a true regime change (in terms of the interest rates and inflation)? I think the key to answering this question is inflation itself, which has been a hot topic since the COVID-19 crisis began in early 2020.

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Interest Rate as Key Indicator

The market will force central banks to raise interest rates, because the Federal Reserve Bank (and other central banks) follow the market – in that order.  Or, put another way, the market always leads the Fed.

When we look at national statistics for month-over-month US inflation, we clearly see overhead resistance at 1%. Sustained monthly, inflation prints above 1% are your bogey, which could set off a cascading event of higher inflation over the next +10 years, and interest rates along with it.

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Monthly US Inflation (25-year lookback)

25-year lookback of monthly US inflation rate

 

Monthly Canada Inflation (25-year lookback)

25-year lookback of monthly inflation rate in Canada

When we look at month-over-month Canada inflation we see a similar resistance point over the past quarter century, so your line in the sand is pretty clear.  

George Soros & Reflexivity

George Soros

George Soros is, of course, one of the most famous hedge fund managers of all time. Aside from his famous bet against the British Pound (GBP) in 1992, he is also well known for his Theory of Reflexivity.

You can think of reflexivity as a feedback loop with two types of reflexive feedback loops that characterize financial markets – namely, negative and positive loops. 

Positive feedback loops produce dynamic disequilibrium and can cause big moves in market prices and the underlying fundamentals. But here is the important part:

A positive feedback loop that runs its entire length is initially self-reinforcing, but it eventually reaches a climax, or reversal point, and then becomes self-reinforcing in the opposite direction.

 

 

Implications for the Relationship Between Interest Rates and Inflation 

Interest rates over the past 40+ years have been fueled lower in a positive feedback loop of sorts. There has been an insatiable hunger for cheap money and more purchasing power (especially after the 2008 Global Financial Crisis), and there is a strong case to be made that this low interest rate cycle has finally come to an end as inflation picks up.

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Put another way, do you really think interest rates will go negative in the United States (or Canada)? In most people’s estimations, this is politically impossible and practically catastrophic. 

It is much more likely that we will look back at 2022 as the beginning of a cycle of higher interest rates that lasts 10-15 years. Interest rates will rise slowly at first, but accelerate once bond markets get spooked. The risk/reward at this juncture suggests that interest rates, at a very minimum, are not going lower. Plan accordingly, as there could be big implications the next time you buy foreign currency

Until next time…

Alex Grant


Alexander Grant, FRM is Olympia Trust CGP’s Head of FX Options Trading. He can be reached at granta@olympiatrust.com if you have questions.

Information provided is for informational purposes only. It is not investment or trading advice, or solicitation for the purchase or sale of any financial instrument.

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